Monday, May 9, 2011

Niall Ferguson on What We Know and the FED Denies

Here is more evidence of my claim that US inflation data are “suspect”. I wrote last week-end in Botoxed U.S. Figures that inflation, were it calculated like it was in the seventies, would be much higher today. I know I am a bit obsessed with the topic (see Why Inflation Will Not Go Away) but it is an important issue for policy, the markets and asset allocation decisions.

Niall Ferguson the Harvard historian, who wrote his Ph.D. dissertation on German hyperinflation, claims that inflation would be above 10% today if we had not made some “methodology adjustments” to compute it “more accurately”.

Moreover, Ferguson claims that “The Fed may deny it, but Americans know that prices are rising.” Obviously, by focusing our attention on core inflation, which excludes food and energy, the FED wants to reduce our long term inflation expectations. But this would be appropriate only if the volatile “food and inflation” component comes back down within a reasonable timeframe. However, there are risks that it may not. In this case, the prudent thing to do would be to extract the trend from this component and add it back into the inflation measure to get an adjusted measure of the core. It is not an obvious thing to do because historical data will point to the absence of an upward trend but forward looking expecations point to the fact that history won't necessarily be a good guide this time around; at least there is a substantial risk that it won't.

It also makes sense for the FED to account for the quality improvement of goods and services when measuring inflation. If you can buy a much better computer for the same price you had paid for your old one, would you not agree that the price of computers is now actually lower? However, it makes comparisons across periods much more difficult. The old computer is not being sold anymore and you still have to fork the money to buy the new one (that is assuming you had one in the first place). Thus, if your income remained the same over the period and the price of food and energy went up (let’s say by the same amount the price of computers went “down”), you either have to sacrifice on the purchase of a new computer or buy less food and energy.

According to the government official statistics, in this simplified example, your real income would have remained constant during the period. And according to economists, you would be a rational consumer. You only eat less food and energy and buy more computer because of the change in their relative prices: food and energy cost more and computer power costs less. But in reality you somehow would still feel poorer.

However, the FED is not only toying with inflation statistics for the sake of “theoretical purity”. Its ulterior motives are to reduce federal government expenses (social security payments and the government employee pensions are indexed for inflation), raise more taxes for the government (tax brackets are also indexed to inflation) and lower interest payments on the national debt. Lower inflation expectation lowers nominal interest rates and lower “measured” inflation reduces interest payments on real return bonds; both of these reduce interest payments on government debt. With motives like these, it is no wonder inflation disappeared from the data. However, this hidden inflation gives the FED incentives to create more inflation than would be optimal. All these tricks are sort of creating a modern version of “money illusion”. However, these may work for a while but eventually inflation and inflation expectations will rear their ugly heads as they won’t remain hidden forever.

Here is Sticker Shock published in Newsweek last week:

“I can’t eat an iPad.” This could go down in history as the line that launched the great inflation of the 2010s.

Back in March, the president of the New York Federal Reserve, William Dudley, was trying to explain to the citizens of Queens, N.Y., why they had no cause to worry about inflation. Dudley, a former chief economist at Goldman Sachs, put it this way: “Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful. You have to look at the prices of all things.” Quick as a flash came a voice from the audience: “I can’t eat an iPad.”

Dudley’s boss, Ben Bernanke, was more tactful in his first-ever press conference on Wednesday of last week. But he didn’t succeed in narrowing the gap between the Fed’s view of inflation and the public’s.

I respect Bernanke. As an expert on the financial history of the 1930s, he was one of the very few people in power back in 2008 who grasped how close we were to another Great Depression. But if we’ve avoided rerunning the 1930s only to end up with a repeat of the 1970s, the public will judge him to have failed.

To this, the Fed has a stock response. It points to the all-urban consumer price index (CPI-U) and notes that it was up only 2.7 percent in March relative to the same month a year earlier. Strip out the costs of food and energy, and “core CPI”—the Fed’s preferred measure—is just 1.2 percent. When Google unveils its new index of online prices, it’s likely to tell a similar story.

To ordinary Americans, however, it’s not the online price of an iPad that matters; it’s prices of food on the shelf and gasoline at the pump. These, after all, are the costs they encounter most frequently. And with average gas prices hitting $3.88 a gallon last week, filling up is now twice as painful as when President Obama took office.

Sensing a threat to his hopes of reelection, the president last week called on Congress to eliminate “unwarranted” tax breaks for oil companies and set up a Justice Department task force to investigate price gouging and fraud in the oil markets. Give me a break. The spike in gas prices is the result of Fed policy, which has increased the monetary base threefold in as many years, and a geopolitical crisis in the Middle East that the president and his advisers still haven’t gotten a handle on.

And the reason the CPI is losing credibility is that, as economist John Williams tirelessly points out, it’s a bogus index. The way inflation is calculated by the Bureau of Labor Statistics has been “improved” 24 times since 1978. If the old methods were still used, the CPI would actually be 10 percent. Yes, folks, double-digit inflation is back. Pretty soon you’ll be able to figure out the real inflation rate just by moving the decimal point in the core CPI one place to the right.

It’s not only the BLS that speaks with a forked tongue. Members of the Council on Foreign Relations last week heard Treasury Secretary Tim Geithner say: “Our policy has been and will always be…that a strong dollar is in the interest of the country.” Fact: the dollar has depreciated relative to other currencies by 17 percent since 2009. That European vacation is going to cost nearly a fifth more than you anticipated when you booked the flights a year ago.

I grew up in the 1970s. My first-ever publication, when I was 10, was a letter to the Glasgow Herald lamenting the soaring price of school shoes (I genuinely thought my feet were growing too fast). I wrote my Ph.D. dissertation about German hyperinflation. So perhaps I’m also hypersensitive. Maybe in June, when the Fed stops quantitative easing (its program of injecting cash by buying government bonds), inflation will recede. Maybe high fuel prices will, as Goldman Sachs predicts, slow the economy and revive the specter of deflation.

Maybe. Or maybe inflation expectations started shifting when the guy from Goldman—a Marie Antoinette for our times—seemed to say: let them eat iPads!

1 comment:

  1. Excellent discussion, most refreshing to see that we old economists are not that stupid,